John Maynard Keynes (1924) We see, therefore, that rising prices [inflation] and falling prices [deflation] each have their characteristic disadvantage. The Inflation which causes the former means Injustice to individuals and to classes--particularly to investors; and is therefore unfavorable to saving. The Deflation which causes falling prices means Impoverishment to labor and to enterprise by leading entrepreneurs to restrict production, in their endeavor to avoid loss to themselves; and is therefore disastrous to employment....
John Maynard Keynes (1924) Thus Inflation is unjust and Deflation is inexpedient. Of the two, perhaps Deflation is, if we rule out exaggerated inflations such as that of Germany [in 1923-1924], the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier. But it is not necessary that we should weight one evil against the other. It is easier to agree that both are evils to be shunned…
Deficits and the Economy Macroeconomists work in three runs: – Short run Productive capabilities of the economy do not change significantly, prices do not fully adjust. Production can deviate from potential output. – Medium run Short-run deviations of production from potential output are ironed out. Prices adjust so inflation finds its level. Economy grows. – Long run Government debt must be paid back (or at least balanced— or defaulted upon
Questions About “Runs” What is the time frame appropriate for each “run”? How do we stitch the conclusions reached by analyzing different “runs” togethere?
The Short Run: The Quantity Theory of Money Start with the quantity theory of money: – PY= MV Federal Reserve controls the money supply M In normal times: – People want to spend the money in their pockets (and bank accounts) by buying stuff at a rate V – If PY too small relative to trend, Federal Reserve pushes M up— and so Y (production and employment) jumps up and P (inflation) accelerates. – If PY too large relative to trend, Federal Reserve pushes M down—and so Y (production and employment) falls and P (inflation) decelerates. – If the rest of the government does something that disturbs this relationship, the Federal Reserve can and does neutralize it Hence fiscal policy should be “classical” rather than “macroeconomic”
The Short Run: But These Times Aren’t Normal The quantity theory of money: – PY= MV What determines V? Why do people want to spend their money? Because holding your wealth in money rather than bonds is expensive: you are losing interest. But what if, in the aftermath of a financial crisis, the short-term interest rate on bonds goes to 0? Then you would rather hold money than bonds: money is safer And the Federal Reserve loses its ability to control the flow of spending
The Short Run: What Is to Be Done? Normally the Federal Reserve boosts the money supply, and people spend more The Federal Reserve can try all kinds of expedients—non- standard monetary policy—to try to cajole people into spending more Or the government can spend more: the government’s money is, as far as buying stuff, as good as anybody else’s – So in the short run—which lasts as long as unemployment is substantially elevated—the government should spend more – And perhaps the government should tax less as a way of cajoling private-sector households to spend more—but that is less certain and sure
How Long Does the Short Run Last? Six years ago, I would have bet serious money that the “short run” is a couple of years—three at most. Now? We are already six years into a “lost decade”. And Japan is now 28 years into its post-Plaza “readjustment”… When will the “medium run” arrive?
Reconciliation of Unemployment and Employment Views The transformation of cyclical into structural unemployment Come 2016, we may no longer be able to use policies to boost employment and production without incurring unacceptable increases in inflation Why? Because once people have dropped out of the labor force, it may be hard to get them back. Each month that the strong recovery we have been waiting for is delayed: – We lose $100 billion in useful commodities we would be producing at full employment, but aren’t. – We lose $267 billion because the fact that people are dropping out of the labor force means that our future booms will be weaker
The Medium Run Someday elevated unemployment will end – Then Y = Y* The equation we then want to look at is the full- employment national income identity – Y* = C(Y-T) + I + G + X If we boost G, we should then also take steps to reduce C by raising T If not, then I will fall And if I falls, growth over a ten-year span will fall And right now it looks as though we don’t have economic growth to spare Don’t cut the parts of G that produce economic growth! Don’t worry about budget balance until the medium-run comes!
Is There a Long-Run Problem? What if our politics remains broken? – “Fiscal dominance” – “Financial repression” – Exorbitant privilege: the U.S. governmente as Renaissance Medici Bank What are our long-run political options? – Pensions, education, health care – Climate change, inequality, intellectual property, robots
Beyond 2025… Stick to PAYGO, no problem… – Milton Friedman’s “A Program for Fiscal Stability” proposal in the early post-WWII years that no government spending program be passed without a funding source If we continue to elect the Republican Party we have had since 1980—well then we have a big problem
And at Some Point the Bond Market Vigilantes May Show Up…
But We Don’t Have to Worry Until After 2025, Right? Right?